US Tax Court cases in a nutshell. There are so many ambiguous areas of the tax code in which the IRS falls back on the old stand by "we'll consider all the facts and circumstances to determine if your position on a tax return should be supported." Tax court cases show us the IRS in action doing just that! (Please note that blogs may include sections copied directly from court case decisions found at ustaxcourt.gov)

Sunday, August 1, 2010

The “Don’t Go Breakin’ My Heart” Case

IRS claims entitlement to a tax deficiency as well as the accuracy-related penalty. Taxpayer claims entitlement to:

1. exclude from income proceeds from a lawsuit against employer for intentional infliction of emotional distress

2. refund of taxes withheld from disability payments

Discussion in a Nutshell:

The taxpayer’s brought a lawsuit against his former employer and two of its employees alleging that the two coworkers engaged in “extreme and outrageous misconduct” that caused him to suffer a second heart attack, rendering him unable to work. A settlement was reached in which the employer paid the taxpayer $34,000 during the disputed year, none of which was reflected on his tax return. The settlement didn't characterize the payment or specifically identify what injury it was for other than using the descripton of “noneconomic damages.” (Under that state's law noneconomic damages do not include punitive damages.)

The IRS argued that the taxpayer’s cause of action was only seeking compensation for emotional distress and not for his physical injuries and therefore none of the settlement proceeds were intended to compensate taxpayer for such. Howeer, the Taxpayer’s suit did mention that the defendant’s action had resulted in substantial medical bills.

On a separate matter, the taxpayer asserted that he had included in his taxable income disability payments which should not have been subject to tax and hoped the court would compel a refund resulting from removal of this income for years 2000-2009.

Decision in a Nutshell:

Settlement proceeds for emotional distress are excludable from gross income only to the extent received attributable to a physical injury or sickness caused by such emotional distress. Otherwise such settlement proceeds are taxable. The court took the position that it was reasonable to construe that the taxpayer’s physical injuries were a prominent component of his “noneconomic damages” and upheld the exclusion of ½ the proceeds from income.

On the other matterr, the court noted that the taxpayer would only be able to exclude the disability payments to the extent they represented a return of his own after-tax premium payments. Taxpayer failed to submit into evidence any record/proof of such payments.

The court refused to apply the accuracy related penalty sought by the IRS since the understatement resulted from a reasonable, good-faith misunderstanding of the tax code.

Take Aways:

• The taxpayer would have been entitled to further exclude any portion of the other ½ of the settlement that represented his medical care costs for emotional distress if he had submitted any such costs into evidence.

• Taxpayer could have further offset with legal fees but was silent about these.

• If settlement proceeds from a case brought for emotional distress include compensation for the resulting bodily harm from such distress then specifically allocating the amount attributable to such in the settlement agreement would be advantageous from a tax strategy perspective.

• The tax court does not have jurisdiction over any other year than the year for which a deficiency has been issued from which the taxpayer has petitioned for relief.

• The tax court inferred that in some cases a failure to seek professional advice to assist with understanding the tax code may count against the taxpayer in their decision regarding liability for the accuracy penalty.